The Stock Market is Stumbling on Nagging Fears the Fed May Have Made a Mistake

September is proving to be a difficult month for the stock market, living up to its reputation as one of the toughest times of the year for investors. This uncertainty looms even as the Federal Reserve prepares to deliver a much-anticipated interest rate cut later this month. However, what’s weighing on investors’ minds is whether the Fed's monetary easing may have come too late.

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Ivan Martchev, an investment strategist at Navellier & Associates, pointed out that while the Federal Reserve might be late in cutting rates, Fed Chair Jerome Powell could still avoid major criticism if he successfully steers the economy clear of a recession. "At this stage, avoiding a recession is still unknowable," Martchev remarked in a note. This uncertainty is fueling investors' concerns, as they remain unsure about the exact timing and impact of the Fed's actions.

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During the first full week of September, U.S. stocks saw significant losses. The S&P 500 dropped 4.3%, while the Dow Jones Industrial Average shed 2.9%, making it the worst week for both indexes since March 2023. The tech-heavy Nasdaq Composite was hit hardest, losing 5.8% for its worst weekly performance since January 2022. Much of the market downturn was attributed to weak economic data, including another lackluster reading from the Institute for Supply Management's manufacturing sector. Though growth in the larger services sector was noted, it did little to brighten the mood among investors.

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Friday’s jobs report for August was highly anticipated as it was expected to provide more clarity regarding the Fed’s upcoming interest rate decision. The Fed had already indicated a likely rate cut at its September 18 meeting, but it remained unclear whether the reduction would be 25 basis points or 50 basis points. The jobs data, however, left the debate unresolved.

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Nonfarm payrolls increased by just 142,000, below expectations of 161,000, and previous months saw downward revisions. This data fueled arguments in favor of a 50 basis point cut. On the other hand, the unemployment rate dipped to 4.2%, and hourly wages rose, providing ammunition for those advocating for a smaller 25 basis point cut. The result was a period of market volatility, with futures traders swinging between expectations of a larger or smaller cut. By the end of the week, the market had settled on a 70% chance of a 25 basis point cut and a 30% chance of a 50 basis point cut, according to the CME FedWatch Tool.

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The attention now shifts to next week’s inflation data, particularly the August consumer price index, which may provide the final piece of the puzzle. Investors have long been calling for rate cuts, entering 2024 with expectations of seven quarter-point reductions. However, significant moves by the Fed can be unsettling. Chris Graham, chief investment officer at Nationwide Financial, noted that a half-point cut might indicate more serious concerns about the economy. He suggested that a more gradual approach of 25 basis point cuts over several meetings would be better received by the market.

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The market and the broader economy are starting to show signs that the Fed's aggressive rate hikes, which brought the federal funds rate from near zero in March 2022 to between 5.25% and 5.5% by July 2023, are having an impact. Larry Adam, chief investment officer at Raymond James, pointed to signs of slowing in rate-sensitive sectors. For example, motor vehicle sales fell to their second-lowest level in 18 months, and construction spending declined for the first time in over 20 months. Low-income consumers are also feeling the strain, as evidenced by weak quarterly results from discount retailers such as Dollar Tree and Dollar General.

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Adding to the market's anxiety, the bond market sent a recession signal on Friday when the 2-year Treasury yield closed below the 10-year yield for the first time since July 2022. This shift in the yield curve has historically been a sign that a recession is near, though it may take time before such an event materializes. September is typically a challenging month for stocks, with the S&P 500 posting an average monthly decline of 1.2% and finishing higher just 44.3% of the time since 1928, according to Dow Jones Market Data. Currently, the S&P 500 is about 4.6% below its record close set in July.

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Despite the recent market turbulence, there are reasons for cautious optimism. Graham noted that while tech stocks, including Nvidia, took significant hits this week, the broader market could benefit from a pullback in the high valuations of some of the biggest players. If the price-to-earnings ratios of top companies fall from lofty levels and other areas of the market see valuation increases, it could create a more favorable investment environment. Additionally, the economy appears to be experiencing the "soft landing" that investors have been hoping for, despite near-term growth concerns.

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Larry Adam from Raymond James remains skeptical about the likelihood of a recession, despite the bond market’s warning. He believes the Federal Reserve has enough tools to navigate through this rough patch and keep the economy on track. Similarly, Martchev from Navellier questioned whether the distinction between a soft landing and a mild recession is even meaningful at this point, as the two scenarios seem increasingly blurred.

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In the end, while September may be living up to its reputation as a rough month for stocks, the broader economic outlook remains uncertain, and much will depend on the Fed’s next steps.

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